Under the current financial system, most money is created not by the government, but through private banks. The Federal Reserve (the U.S. central bank, which is part of the government) controls the monetary base, such as coins and notes. These are the most tangible kind of currency, but there are many other types of things also called "dollars" that are used for exchange.

Most obviously, there is credit. Banks can lend — and thus create credit — up to 10 times their reserves on hand. This means that in the current system, the size of the money supply adjusts automatically to market demand for money. But this does not encompass the entirety of the money supply.

There exists another banking system — the shadow banking system— where credit creation also takes place. Shadow credit is created via securitization, a process through which debt-based assets like mortgages, credit card debt, and auto debt are pooled together and sold, and via repo, through which assets are pawned to a lender as collateral for credit.

One of the key developments preceding the 2008 crisis was the explosive outgrowth of shadow credit creation. Yet when the crisis hit, credit markets became spooked, there was a massive run on shadow banks, shadow credit creation dried up, and the level of shadow assets began to dramatically deflate.

This seems to have occurred because regulators did not recognize that shadow banking was actually banking. Central banks can prevent bank runs by acting as a lender of last resort. If banks run out of reserves, the central bank can lend them more to ease customers' fears and end the bank run. Furthermore, the FDIC insures deposits such that if a conventional bank fails, customers get up to $250,000 of their money back. These assurances kept the financial sector relatively strong after the Great Depression — a crisis that certainly involved large numbers of bank runs. But these assurances did not extend to shadow banks. There were, in other words, things that were acting as banks, but which weren't being regulated as banks.

In recent years, it has become fashionable in some circles to propose an end to money creation through lending. This was actually first proposed during the Great Depression by the economist Irving Fisher. The basic idea is that if you stop credit creation from determining the size of the money supply, you make the money supply less fragile to collapse. And by making banks keep everything they owe to customers on hand, you make banks invulnerable to bank runs, where bank customers become spooked, and withdraw their money en masse.

The International Monetary Fund recently published such a proposal based on Fisher's Chicago Plan. Boston University economist Laurence Kotlikoff published another. Chicago University economist John Cochrane published yet another.

Most visibly, the Financial Times' Martin Wolf suggested last week that banks should be stripped of their ability to create money through lending.

Wolf calls for all money to be created by the state. Wolf explains how this would work as follows:

First, the state, not banks, would create all transactions money, just as it creates cash today. Customers would own the money in transaction accounts, and would pay the banks a fee for managing them.

Second, banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.

Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

Finally, the new money would be injected into the economy in four possible ways: to finance government spending, in place of taxes or borrowing; to make direct payments to citizens; to redeem outstanding debts, public or private; or to make new loans through banks or other intermediaries. All such mechanisms could (and should) be made as transparent as one might wish. [Financial Times]

The really strange thing about these kinds of proposals, as Paul Krugman argues, is that they act like conventional bank runs were a problem in 2008. They weren't. Bank runs have largely been prevented since the Great Depression by the existence of a lender of last resort and deposit insurance. In fact, the crisis of 2008 involved very few runs on conventional deposits but a massive run on shadow banking. The shadow banking sector was a huge new sector of things that acted like banks that, crucially, were not regulated as banks, and had no access to a lender of last resort.

Ordering banks to only lend what money they have on hand, called "full reserve banking," would make matters much, much worse.

The main way banks traditionally make money is by acting as intermediaries between depositors and borrowers. Banks pay an interest rate to depositors for their money, and receive a higher interest rate from borrowers for lending to them. If banks have to keep 100 percent of the money that depositors deposit on hand, they can't make loans. This reduces the role of banks from being an intermediary between depositors and borrowers to simply being a place for depositors to keep their money. As Wolf recognizes, this would make taking deposits totally unprofitable.

Zero-profit banks would struggle to pay depositors anything for their money. In fact, given that banks would be providing a service of keeping money safe, and operating a payments system, it's possible that customers would have to pay banks for the pleasure of holding their money. As Wolf notes, this could mean that a full reserve banking system might have to be taken over by the government and run as a public utility. But even then, depositors could not get much interest.

Depositors don't tend to want to deposit their money for nothing, or less than nothing. This is true not least because they want to be paid interest to insure against inflation. This strongly suggests that a ban on fractional banking would just drive savers reaching for yield into vehicles like mutual funds, money market funds, and exchange traded funds, which aren't insured and have no access to a lender of last resort, and so would also be even more vulnerable to runs. In other words, more shadow banking.

And it would also open the door to the possibility of black market banking deposits — unregulated groups offering higher interest rates, but where deposits aren't insured, and where banks don't have access to a lender of last resort. Prohibition of alcohol did not eradicate the use of alcohol. It just created a black market for booze that enriched violent gangsters like Al Capone. Similarly, full reserve banking would just create a giant black market for money.

In other words, banking would be set back over a hundred years. Depositors might get higher interest rates for their money in the black market than in the full-reserve mainstream. But without insured deposits, and lenders of last resort, depositors who want a decent interest rates would have to risk losing it all.

So the answer is not prohibition. Like with liquor, that will just magnify the problem.